The Japanese bond purchase programme has already had a material effect on financial prices around the world. It will now alter the global investment landscape by changing the nature and size of capital flows. Yet once the initial excitement passes, the real question will become whether it adds to, or subtracts from, the longer-term stability of the global monetary system.
The Japanese programme is massive: in absolute terms (some $75bn per month); relative to where bond prices stood (the 10-year Japanese government bond interest rate was already very low); and even compared to the Federal Reserve’s QE3 (which involves monthly purchases of $85bn for an economy with a GDP three times larger than Japan’s). Anchored by a 2 per cent inflation objective, the Japanese programme is also slotted to persist for a long time.
Realising this, market participants have already adjusted financial prices. The most dramatic move is in the yen, and justifiably so: unlike the US, where domestic components of aggregate demand would be expected to do the heavy lifting, the Japanese programme’s success depends on its ability to capture market share from other countries.
The currency moves have also been turbocharged by the green light given to Japan by other advanced countries. For now, G7 countries are making a distinction between explicit foreign exchange intervention (still frowned on) and this type of approach to weakening a currency.
Meanwhile, recognising that the economy is in no position to absorb the liquidity injected by the Bank of Japan, markets are also anticipating capital flows out of Japan. The result is a cascading valuation waterfall. It started by benefiting any and all higher-income producing fixed income securities, then pushed higher global equities and other more risk-oriented investment opportunities.
All this happened irrespective of the underlying fundamentals. This is what excites global investors in the short run, but makes them more anxious about the longer term.
It excites them because yet another central bank is now actively involved in creating a significant wedge between sluggish fundamentals and higher financial prices. And so investors continue to ride wonderful liquidity waves that divorce valuations from top line revenue growth and profitability.
Yet it makes investors more anxious because they recognise it may all end in tears if real economies do not respond adequately to central bank policies. Here, the risk is that artificially high asset prices would eventually collapse to levels warranted by fundamentals.
The resolution of this anxiety is not in the hands of central banks alone. It also depends on proper responses by other policy makers, on less obstructive politicians, and on the proper engagement of strong corporate balance sheets. In the meantime, we should expect at least two developments that will add to the twin emotions of excitement and anxiety.
First, Japan’s programme increases the probability that other central banks will be pushed into adopting more expansionary monetary policies. This is particularly the case for economies directly affected by the sharp depreciation of the yen, such as Korea and members of the eurozone. It is also true of those (such as Brazil and Mexico) that experience surges in capital inflows due to Japan’s actions.
Second, the programme will add to worries about market malfunction. This speaks to more than increasing episodes of illiquidity and price gapping already evident in the market for Japanese government bonds. It includes growing concerns about the poor information content of prices in today’s global markets, and how the artificial price signalling distorts the allocation of resources and misaligns incentives (across time, and among different market participants).
Such concerns would be tempered if real economies were to respond quickly and properly to central bank actions. But they are not, and for understandable reasons.
While officials recognise the importance of supporting policies that improve economic responsiveness and longer-term financial viability, these are yet to be put in place. Witness how Congressional dysfunction is paralysing movement on virtually any policy front in the US. And even Japan’s recently announced programme lacks proper specification when it comes to the structural reforms that are essential to increasing nominal GDP in a sustainable fashion.
Global investors are right to be excited by Japan’s bond purchase programme. It has already had a material impact. Yet where it can be a real game changer is in how it alters the dynamic of the longer-term switchover from artificial growth to genuine growth. Here, investors are right to be anxious.
Mohamed El-Erian is chief executive and co-chief investment officer of Pimco